Tax Brief. 3 November Transitionally GST-Free Contracts 1 July 2005 Legislative Fix. STOP PRESS: 11 February Summary

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1 Tax Brief 3 November 2004 Transitionally GST-Free Contracts 1 July 2005 Legislative Fix STOP PRESS: 11 February 2005 The legislation giving effect to the end of GST-free transitional relief passed through Parliament on 8 February 2005 with only one minor Senate amendment which the House of Representatives approved. Royal Assent is expected shortly for the legislation the Tax Laws Amendment (Long-term Non-reviewable Contracts) Act 2005, which amends the GST Transition Act. The one amendment sets a 28 days time limit from the end of the initial offer period (ie the offer made by the supplier) for an assessor appointed by an arbitrator to assess an appropriate change. It is unclear what will happen if the 28 day timeframe isn t met, but the amendment serves to strengthen the supplier s position by capping, at least in theory, the price change process to under 3 months. The Regulations which will identify who can act as arbitrators/assessors are yet to be drafted. Suppliers will still need to act quickly to draft and send initial offer letters as there is only just over four and a half months until the transitional GST-free treatment ends. Summary In line with the policy originally announced in May 2000 (and revised in November 2003), the Federal Government has now released draft legislation aimed at providing relief for suppliers under transitionally GST-free contracts when the transitional treatment expires on 1 July Treasury is seeking comments on the proposed amendments by 12 November 2004 with a view to introducing them into Parliament in the remaining 2004 sittings. The proposed Amendments to the A New Tax System (Goods and Services Tax Transition) Act 1999 will allow suppliers to effectively pass on the GST imposed after 1 July 2005 by requiring recipients to either accept an increase in the price of the supply or pay 10% GST themselves (through a reverse charge mechanism).

2 The key features of the Amendments are: recipients of supplies that will become taxable after transitional GST-free treatment ends on 1 July 2005 can agree to pay the GST themselves (10% of the current GST-exclusive price) or will be forced to do so if they do not accept an arbitrated offer (unless their agreement expressly disallows any price increase for GST); a supplier can make an arbitrated offer for a GST related price increase by following a process requiring an initial offer and, if rejected, a final offer of an amount determined by an independent assessor; and the assessor must determine the appropriate change in consideration based solely on the impact of the New Tax System changes on the supplier s costs and expenses (it is not a market review). The Amendments essentially encompass the Government s proposal in its 21 November 2003 press release and Treasury Paper. One noticeable (and welcome) modification is that recipients will reverse charge their GST liability if applicable (in line with similar existing provisions in the GST Act) rather than the liability being collected and remitted by the supplier. As a result, affected suppliers (such as lessors of grandfathered leases) will now need to consider their position and prepare for the price change process to ensure it is completed by 1 July 2005 in order to avoid becoming liable for unrecoverable GST. Affected recipients (such as lessees under grandfathered leases) will need to consider the costs and benefits of the reverse charge option versus the offered price changes. We note, however, that the Amendments will not apply for all grandfathered contracts. They have no effect if an agreement specifically disallows any price increase for GST. Also, the offer mechanism may not be legally possible or effective where the consideration for a supply is set by legislation or trust deed. Suppliers in these cases will bear the GST after 1 July Issues for Suppliers (e.g. Lessors) Required Process & Timeframe The price change process contemplated in the Amendments may take up to six months or it may be completed in a day if the recipient agrees to become liable itself or accepts the initial offer. In any case, if the process has not been completed by 1 July 2005, the supplier will start losing revenue as it will become liable for GST of 1/11th of the existing price. So suppliers should start planning the price change process as soon as possible. 2 Transitionally GST-Free Contracts 1 July 2005 Legislative Fix

3 The steps a supplier will need to take are: 1 Step 1: The supplier must make an initial offer of a price increase. It may at the same time inform the recipient that it may choose to pay GST itself under the reverse charge mechanism; 2 Step 2: The initial offer must be open for at least 28 days. In this time the recipient may: (1) accept the offer; (2) reject the offer; or (3) agree to pay the GST itself. If the recipient chooses option 1 or 3 (and notifies the supplier in writing), the process is finished. 3 Step 3: If the recipient rejects the offer or does not respond within the minimum 28 day offer period, the supplier can apply to the arbitrator to appoint an assessor. The potential arbitrators will be identified in yet to be drafted Regulations; 4 Step 4: The assessor must determine the appropriate change to the consideration (see below); 5 Step 5: The supplier must then make the final offer of a price increase as determined by the assessor and this final offer must be open for 21 days; and 6 Step 6: After the 21 day period, if the recipient has not accepted the arbitrated offer it will become liable for GST itself after 1 July 2005 under the reverse charge mechanism. Appropriate Change in Price The Amendments set no limit as to what price increase the supplier can offer in the initial offer. However, for the initial offer to have any credibility, and to follow the clear intention of the legislation, we suggest that the initial offer should be the supplier s estimate of the appropriate change that an assessor would arrive at under proposed section 15L. To determine the appropriate change the assessor must only take into account the impact of the New System Tax changes (as defined in the Trade Practices Act) on the supplier s costs and expenses. This is similar to the price change exercise that most suppliers would have undertaken in the lead up to the introduction of GST in order to avoid breaching the price exploitation provisions of the Trade Practices Act. Treasury s November 2003 proposal reflected this, explaining the three factors in the calculation of an appropriate change in price as: The direct cost of GST on the supply (10%); Cost reductions of the supplier relating to the supply arising from the abolition of other taxes when GST was introduced; and 3 Transitionally GST-Free Contracts 1 July 2005 Legislative Fix

4 The net recurrent compliance costs of the supplier associated with the imposition of GST on the supply. Theoretically, the appropriate change may be greater than 10%, as a supplier might be incurring more net recurrent compliance costs than they achieved cost reductions particularly over four years from the start of GST and abolition of most of the other taxes. However, in practice the recipient can effectively cap any price increase at 10% by electing to pay the GST itself. Practically, suppliers with grandfathered agreements will need to dust off any economic modelling they undertook, if any, to estimate the impact of the New Tax System changes on 1 July 2000 and update it for the reality of costs savings achieved and compliance costs incurred. Legal Form & Stamp Duty Issues In making the initial and, if necessary, final offers, suppliers will need to consider what legal form the offers should take if they will effectively vary a written contract. This issue may differ depending on what the original agreement is (ie. lease, deed, etc) and even in what state the contract was made. Stamp duty implications should also be carefully considered (eg to what extent should leases be upstamped ). Issues for Recipients (e.g. Lessees) Recipients of supplies that are currently GST-free due to section 13 of the GST Transition Act will need to consider which option provided under the Bill will give them the best commercial result. This may depend on the individual circumstances of the recipient such as whether it is entitled to full, partial or no input tax credits on those supplies or whether a price increase has other ramifications (such as an increased stamp duty or land tax cost). Generally, the recipient will have three options: choose to be liable for the GST itself (the reverse charge, so called because it reverses the usual position of GST liability falling on the supplier); agree to the initial offer; or seek arbitration for a better final offer. Advantages for Electing to Reverse Charge For many recipients there may be advantages in electing to reverse charge the GST, particularly where the recipient will be entitled to a full input tax credit on the supply. This is because the reverse charge for such recipients will merely be a paper transaction recording the amount payable as GST and the amount claimable as an input tax credit, which offset each other, in each BAS without having to make any payment or hold any tax invoice. 4 Transitionally GST-Free Contracts 1 July 2005 Legislative Fix

5 Some of the advantages of agreeing to reverse charge the GST could be: Cashflow: if the recipient usually pays for the supply before it would claim its input tax credit, then electing to reverse charge will eliminate the cashflow disadvantage of having to wait for the input tax credit; Minimise risk: not needing a tax invoice eliminates the risk of claiming a credit on an invalid tax invoice; Stamp duty & land tax: If an increase in the price for the supply would create or increase a stamp duty liability or land tax liability, then there would be cost savings in electing to reverse charge the GST. Advantages and Risks of Price Increase There is obviously a saving to a recipient who is entitled to full input tax credit in choosing to agree to such a price increase of less than 10%. Even a recipient who cannot claim a full input tax credit is better off, for GST recovery purposes at least, accepting a price increase of less than 10% rather than electing to reverse charge. One risk to a recipient may be that if it rejects an initial offer hoping that an assessor will determine a lower price increase, it will be stuck with the assessor s determination even if it is higher than the initial offer. Fortunately, the risk in this scenario is capped at a 10% increase as the recipient can always elect to reverse charge the GST if an assessor determines a price increase above 10%. Other Issues A summary of other key aspects of the Bill includes: parties to grandfathered contracts will have some flexibility on when the price increase can take effect before 1 July 2005; the carrying out of the price change processes will not of themselves ungrandfather GST-free supplies; suppliers will not be required to issue tax invoices and adjustment notes for supplies where the recipient reverse charges the GST; special rules will exist for unregistered recipients who become liable to reverse charge GST; and two matters are left to be set out in Regulations: the arbitrator and the form of the assessor s determination. 5 Transitionally GST-Free Contracts 1 July 2005 Legislative Fix

6 For further information, please contact Sydney Andrew Howe G&F document ID _15.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Transitionally GST-Free Contracts 1 July 2005 Legislative Fix